Looking for yields? Consider foreign bonds

July 10, 2013

Due to the recent Fed announcement that it planned to trim its $85 billion per month bond purchases, the U.S. bond market has taken it on the chin in the last month. Interest rates have risen, which sends bond prices down. In my practice with mostly retired clientele, we are very underweight with bonds on our asset allocation. The question is where one finds opportunity in the bond market going forward.

Investors in the hunt for higher yields have to search far and wide and consider avenues they may not have investigated before. One investment type that may be worth a look is foreign bonds and foreign bond funds.

Investing in foreign bonds can have a number of advantages, including that the returns from foreign bonds are typically higher than returns offered via U.S. Treasury securities. However, Treasury securities are guaranteed as to the timely payment of principal and interest, which cannot be guaranteed for many foreign bonds. The monetary and budget policies of many foreign nations are often different than those of the United States, which can help your portfolio diversification – low correlation.

There are many types of foreign bonds, both from government entities as well as corporations:

• Eurobonds: A eurobond is a bond issued and traded in a country other than the one in which its currency is denominated –- not always a European nation. Eurobonds give issuers the flexibility to choose the country in which to offer their bond according to that country’s regulatory constraints. They are usually issued in more than one country of issue and traded across international financial markets. But they are unsecured, leaving bondholders without the first claim to the issuer’s assets in case of default.

• Global bonds: A global bond is a type of bond that is issued in multiple markets in different currencies. By issuing global bonds, a government or corporation is able to attract funds from a wider set of investors and potentially reduce its cost of borrowing.

• Sovereign bonds: Issued by national governments, sovereign bonds are generally among the safest investments in most countries. Even if countries are not particularly creditworthy, their sovereign bonds are usually safer than their other domestic alternatives.

Yankee bonds: Yankee bonds are U.S. dollar-denominated bonds issued by foreign governments and corporations and sold in the United States. American investors can purchase the securities of foreign issuers without being subject to price swings caused by variations in currency exchange rates. As a result, Yankee bond prices are influenced primarily by changes in U.S. interest rates and the financial condition of the issuer.

Investment risks

As with all types of investments, there are a number of risks associated with foreign bonds:

• Currency risk: Any time you hold a foreign currency, you are subject to currency risk, which is the potential for loss due to fluctuations in exchange rates. Currency risk can literally turn a profit on a foreign investment into a loss. A falling dollar benefits and visa versa.

• Sovereign risk: This is the risk of a government becoming unwilling or unable to meet its loan obligations, or reneging on loans it guarantees. This risk is especially present in emerging markets, where governments are more likely to be unstable.

• Inflation risk:- As inflation rises, bonds that have already been issued lose value in the secondary market. In an inflationary environment, bonds issued more recently are usually more attractive because they’ll often have higher interest rates, as central banks such as the U.S. Federal Reserve and European Central Bank often raise rates in response to inflation fears.

• Liquidity risk: As with many U.S. corporate bonds, it can be difficult to find a buyer for an international government or corporate bond.

Which foreign bonds or bond funds best complement your portfolio will depend on a number of factors, including your existing holdings and appetite for risk. Foreign bonds are foreign to many investors. They are very different in many ways from investing in our bond market. Do your homework before taking the plunge in order to avoid potential surprises.